Edward Harrison here. This is an updated version of a post I wrote about two-and-a-half months ago over at Credit Writedowns. When I wrote it, I had been looking for bullish data points as counterfactuals to my bearish long-term outlook. I found some, but not nearly enough.

Early this year, I wrote a post “We are in depression”, which called the ongoing downturn a depression with a small ‘d.’ I was optimistic that policymakers could engineer a fake recovery predicated on stimulus and asset price reflation – and this was bullish for financial shares if not the broader stock market. But, we are witnessing temporary salves for a deeper structural problem.

So my goal was to find data which disproved my original thesis. But, I came away more convinced that we are in a tenuous cyclical upturn. This post will discuss why we are in a depression, not a recession and what this means about likely future economic and investing paths. I pull together a number of threads from previous posts, so it is pretty long. I have shortened it in order to pull all of the ideas into one post. So, please read the linked posts for background as I left out a lot of the detail in order to create this narrative.

I see the debt problem as an outgrowth of pro-growth, anti-recession macroeconomic policy which developed as a reaction to the 1970s lost decade trauma in the U.S. and the U.K.. The 70s was a low growth, high inflation ride that generated poor market returns. The U.K. became the sick man of Europe and labor strife brought the economy to its knees. For the U.S., we saw the resignation of an American President and the humiliation of the Iran Hostage Crisis.

In essence, after the inflationary outcome that many saw as an outgrowth of the Samuelson-Keynesianism of the 1960s and 1970s, the Reagan-Thatcher era of the 1990s ushered in a more ‘free-market’ orientation in macroeconomic policy. The key issue was government intervention. Policy makers following Samuelson (more so than Keynes himself) have stressed the positive effect of government intervention, pointing to the Great Depression as animus, and the New Deal, and World War II as proof. Other economists (notably Milton Friedman, and later Robert Lucas) have stressed the primacy of markets, pointing to the end of Bretton Woods, the Nixon Shock and stagflation as counterfactuals. They point to the Great Moderation and secular bull market of 1982-2000 as proof. This is a divisive and extremely political issue, in which the two sides have been labeled Freshwater and Saltwater economists (see my post “Freshwater versus saltwater circa 1988”).

The 1970s was a difficult period in which the U.K. and the U.S. saw jobs vanish in key industrial sectors. To stop the rot and effectively mask the lack of income growth by average workers, a new engine of growth had to be found. Enter the financial sector. The financialization of the American and British economies began in the 1980s, greatly increasing the size and impact of the financial sector (see Kevin Phillips’ book “Bad Money”). The result was an enormous increase in debt, especially in the financial sector.

This debt problem was made manifest repeatedly during financial crises of the era. Not all of these crises were American – most were abroad and merely facilitated by an increase in credit, liquidity, and international capital movement. In March 2008, I wrote in my third post on the US economy in 2008:

From the very beginning, the excess liquidity created by the U.S. Federal Reserve created an excess supply of money, which repeatedly found its way through hot money flows to a mis-allocation of investment capital and an asset bubble somewhere in the global economy. In my opinion, the global economy continued to grow above trend through to the new millennium because these hot money flows created bubbles only in less central parts of the global economy (Mexico in 1994-95, Thailand and southeast Asia in 1997, Russia and Brazil in 1998, and Argentina, Uruguay, and Brazil in 2001-03). But, this growth was unsustainable as the global imbalances mounted.

Eventually, the debt burdens became too large and resulted in the housing meltdown and the concomitant collapse of the financial sector, a problem that our policymakers should have foreseen and the reason my blog is named Credit Writedowns. Make no mistake, the housing and writedown problems are only symptoms; the real problem is the debt – specifically an overly indebted private sector (note the phrase ‘private sector’ as I will return to this topic).

This is a depression, not a recession

When debt is the real issue underlying an economic downturn, the result is either Great Depression-like collapse or a period of stagnation and short business cycles as we have seen in Japan over the last two decades. This is what a modern-day depression looks like – a series of W’s where uneven economic growth is punctuated by fits of recession.

A garden-variety recession is merely a period of recalibration after businesses get ahead of themselves by overestimating consumption demand and are then forced to cut back by making staff redundant, paring back inventories and cutting capacity. Recessions can be overcome with the help of automatic stabilizers like unemployment insurance to cushion the blow.

Recessions are typically characterized by inventory cycles – 80% of the decline in GDP is typically due to the de-stocking in the manufacturing sector. Traditional policy stimulus almost always works to absorb the excess by stimulating domestic demand. Depressions often are marked by balance sheet compression and deleveraging: debt elimination, asset liquidation and rising savings rates. When the credit expansion reaches bubble proportions, the distance to the mean is longer and deeper. Unfortunately, as our former investment strategist Bob Farrell’s Rule #3 points out, excesses in one direction lead to excesses in the opposite direction.

The day after I highlighted Ray Dalio’s version of this story which added some more color. Notice the part about printing money and devaluing the currency if the debt is in your own currency.

… economies go through a long-term debt cycle — a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren’t adequate to service the debt. The incomes aren’t adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring…

This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.

We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes — the cash flows that are being produced to service them — or we are going to have to raise incomes by printing a lot of money.

It isn’t complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue…

The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.

However, the reason it hasn’t actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece — banks and investment banks and whatever is left of the financial sector — that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.

The Fake Recovery

So where are we, then? We are in a fake recovery that could last as long as three or four years or could peter out very quickly in a double dip recession. You may have seen my April post on the fake recovery. Read it. I won’t cover that ground here. However, I will highlight how I came to believe in the fake recovery and how asset prices have played into this period (the S&L crisis played out nearly the same way). I see writedowns as core to the transmission mechanism of debt and credit problems to the real economy via reduced supply and demand for credit. Again, this is why my site is called Credit Writedowns.

The problem is the writedowns. You see, if you get $30 billion in capital from the government, but lose another $40 billion because of credit writedowns and loan losses, you aren’t going to be lending any money. To me, that says the downturn will only end when the massive writedowns end, not before.

The U.S. government has finally realized this and is now moving to stem the tide. Their efforts point in four directions:

Increase asset prices. If the assets on the balance sheets of banks are falling, then why not buy them at higher prices and stop the bloodletting? This is the purpose of the TALF, Obama’s mortgage relief program and the original purpose of the TARP.

Increase asset prices. If assets on the balance sheet are falling, why not eliminate the accounting rules that are making them fall? Get rid of marking-to-market. This is the purpose of the newly proposed FASB accounting rule change.

Increase asset prices. If asset prices on the balance sheet are falling, why not reduce interest rates so that the debt payments which are crushing debtors ability to finance those assets are reduced? This is why short-term interest rates are near zero.

Increase asset prices. If asset prices on the balance sheet are falling, why not create Public-Private partnerships to buy up those assets at prices which reflect their longer-term value? This is what Geithner’s Capital Assistance Program is designed to do.

So I lied, there is only one direction the government is headed: increase asset prices (or, at least keep them from falling). Read White House Economic Advisor Larry Summers’ recent prepared remarks to see what I mean. (Summers on How to Deal With a ‘Rarer Kind of Recession’ – WSJ)

I was more on target in my thinking here than I could have known. The mark-to-market model died and mark-to-make believe began. It was then that I knew a recovery was likely to take hold. And it was going to be bullish for bank stocks and the broader market. What you should realize is that, despite the remaining problems in credit cards, commercial real estate or high yield loans, limiting credit growth, the changes instituted by government definitely have meant 1. that banks will earn a shed load of money and 2. that house price declines have stalled, underpinning the asset base of lenders. This necessarily means an end to massive writedowns, a firming of banks’ capital base, and a reduction in private sector deleveraging. And the recent brouhaha over Citi’s favorable tax deal in exiting TARP should tell you the government will stop at nothing to keep accounting favorable for the big banks.

As for the recent asset-based economic reflation, be under no illusion that these measures ‘solve’ the problem. The toxic assets are still toxic and banks are still under-capitalized. But increased asset values and the end of huge writedowns has underpinned the banks and led to a rise in the broader market in a feedback loop that has been far greater than I could have imagined at this stage in the economic cycle.

The double dip or the economic boom?

So what’s next? A lot of the economic cycle is self-reinforcing (the change in inventories is one example). So it is not completely out of the question that we see a multi-year economic boom. Higher asset prices, lower inventories, fewer writedowns all lead to higher lending capacity, higher cyclical output, more employment opportunities and greater business and consumer confidence. If employment turns up appreciably before these cyclical agents lose steam, you have the makings of a multi-year recovery. This is how every economic cycle develops. This one is no different in this regard.

Now, I have turned slightly more dour of late and see a double dip as more likely in the medium-term. Longer-term, things depend on government because we are in a balance sheet recession. Ray Dalio and David Rosenberg make this case well in the previous quotes I supplied, but it was a post about Richard Koo from Prieur du Plessis which originally got me to write this post. His post, “Koo: Government fulfilling necessary function” reads as follows:

According to Koo, American consumers are suffering from a balance sheet problem and will not increase consumption until their personal finances are back in order. The banks are not lending mainly because nobody wants to borrow and, furthermore, the banks want to build their own balance sheets (raise cash) and get rid of toxic garbage…

Again, when asked what would happen if the government cuts back on its fiscal stimulus, Koo replies: “Until the private sector is finished repairing its balance sheets, if the government tries to cut its spending, we’re going to fall into the same trap Franklin Roosevelt fell into in 1937 (a crushing bear market) and Prime Minister Hashimoto fell into in 1997, exactly 70 years later.

“The economy will collapse again and the second collapse is usually far worse than the first. And the reason is that, after the first collapse, people tend to blame themselves. They say, ‘I shouldn’t have played the bubble. I shouldn’t have borrowed money to invest – to speculate on these things.’

The U.S. economy cannot possibly work itself out of the greatest financial crisis in some 70-odd years in a mere 4 years and then expect to raise taxes on the middle class without a major recessionary relapse.

So, when you hear policy makers talking about reducing the deficit as soon as possible, what you should think is 1938 and continued depression.

Right now, if you listen to what President Obama is likely to do, you know that the government prop for the economy is going to be taken away. Get ready because the second dip will occur. It will be nasty: unemployment will be higher and stocks will go lower than in 2009. I The question now is one of timing: when will the government stop propping up the economy? The more robust the recovery, the quicker the prop ends and the sooner we get a second leg down.

So to recap:

A depression was borne out of high levels of private sector debt, the unsustainability of which became apparent after a financial crisis.

The effects of this depression have been lessened by economic stimulus and government support.

Government intervention led to a reduction in asset price declines, which led to stock market increases, which led to asset price stabilization and more stock market increases and eventually to asset price increases. This has led to a false sense that green shoots are leading to a sustainable recovery.

In reality, the problems of high debt levels in the private sector and an undercapitalized financial system are still lurking, waiting for the government to withdraw its economic support to become realized

Because large scale government deficit spending is politically unpalatable and unsustainable over the long-term, expect a second economic dip within three to four years at the latest.

Why is government spending key?

The government plays a crucial role here because of the huge private sector indebtedness. In the U.S. and the U.K., the public sector is not nearly as indebted. So while, the private sector rebuilds its savings and reduces debt, the public sector can pick up the slack. Marshall Auerback says it best in a recent post:

We’ve said it before and we’ll say it again. As a matter of national accounting, the domestic private sector cannot increase savings unless and until foreign or government sectors increase deficits. Call this the tyranny of double entry bookkeeping: the government’s deficit equals by identity the non-government’s surplus.

So, if the US private sector is to rebuild its balance sheet by spending less than its income, the government will have to spend more than its tax revenue. The only other possibility is that the rest of the world stops saving on a massive scale — letting the US run a current account surplus. But that is highly implausible and socially undesirable, since it means we export our economic output, rather than consume it domestically. And if the government deficit does not grow fast enough to meet the saving needs of the private domestic sector, national income will decline, which, given the size of the private sector’s debt problem, will generate a huge debt deflation.

This is the foundation of modern monetary theory. Would that the IMF and the G20 understood these basic facts.

If the private sector is a net saver, the public sector must run a deficit. The only other way to prevent the government from running a deficit when the private sector is net saving is to run huge current account surpluses by exporting your way out of recession – what Germany and Japan tried in the 1990s and in this decade.

However, I must admit to having a preternatural disaffection for large deficits and big government which is what Koo and Minsky advise respectively. It is this knee-jerk aversion to what is viewed as fiscal profligacy which makes it likely that the government prop will be taken away inducing another downturn.

So, what does this mean for the American and global economy?

The private sector (particularly households) is overly indebted. The level of debt households now carry cannot be supported by income at the present levels of consumption. The natural tendency, therefore, is toward more saving and less spending in the private sector (although asset price appreciation can attenuate this through the Wealth Effect). That necessarily means the public sector must run a deficit or the import-export sector must run a surplus.

Most countries are in a state of economic weakness. That means consumption demand is constrained globally. There is no chance that the U.S. can export its way out of recession without a collapse in the value of the U.S. dollar. That leaves the government as the sole way to pick up the slack.

Since state and local governments are constrained by falling tax revenue (see WSJ article) and the inability to print money, only the Federal Government can run large deficits.

Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.

Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.

I believe this dynamic will induce a Scylla and Charybdis of inflationary and deflationary forces, forcing central bankers to add and withdraw liquidity in a manic way. The likely volatility in government spending and taxation gives you the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.

Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.

From an investing standpoint, consider this a secular bear market for stocks then. Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

61 Responses to “The recession is over but the depression has just begun”

I agree. The problems are structural. They will not be fixed w/out pain, no matter what fantasy the government tries to impose through its profligate borrowing to spend. We’ve rewound the clock to 2007. That didn’t turn out so well the first time. It won’t turn out so well this time, either.

“While his 2010 S&P target would equate to around Dow 13,000, “we could very easily be at 10,000 [again] in two-three-four years from now [but] the way we get it is a lot of volatility – a lot of up and down,” Ritholtz says. “The goal from now until let’s call it 2015 is to preserve capital — see if you can make a little money here or there – but be ready for the next 15-to-20 year bull market.”

Mr. Harrison states: “From the very beginning, the excess liquidity created by the U.S. Federal Reserve created an excess supply of money, which repeatedly found its way through hot money flows to a mis-allocation of investment capital and an asset bubble somewhere in the global economy.”

I will continue to argue that the low interest rate policy of the Federal Reserve in the early 2000s was the correct course of action for that period of time and it did not the cause of the excess money supply and liquidity that sloshed around the financial system. Rather it was the decisions that allowed banks to pursue unlimited leverage, both on and off balance sheet, that created this excess supply of money, and to the extent the Federal Reserve supported and advocated for this, yes, they did in fact create an excess supply of money. But it was the deregulation not the low interest rates that was the culprit. Go back and replay 2001 – 2007 with banks maintaining leverage ratios of 12 – 1. Think through how banker’s capital allocation decisions would have been affected if the amount of funds that the banks had available to loan was scarce (12 to 1) rather than unlimited (40 to 1 + SIVs & CDOs). Under this set of circumstances the low interest rates would have help to finance projects with long term ROI characteristics rather than short-term consumption and the encouragement of fraudulent lending practices by all parties to the loan transactions simply to generate more assets.

The future would have been much different and in a positive way. Just food for thought.

This commentary is couched totally in terms of aggregates. It may be interesting to play this aggregate game and toy with financial assets, interest rates et al, but as with all the macroeconomic game playing, its capacity to show us what will happen at micro ground level in the economy, the real economy, the shifts in wants, business and household responses to price signals, people’s response to job prospects, business and household reponses to tax implications of government policies, the real and actual allocation of scarce resources, for this its contribution is absolutely zilch.
Yet this is what we really wish to know: the real shape of the US economy two, five and ten years down the road.
Macroeconomics is truly Panglossian: it always assumes the best of all possible worlds when governments spend and raise debt “to close output gaps and boost aggregate demand”. Would that Keynes had never invented the philosophy and aggregate terms because all it has done is lend power to politicians and the government bureaucracy to waste money, misallocate resources, pursue pet projects, expand its reach and authority, and generally ensure sub-optimal growth and productivity.
So interesting as Edward Harrison’s essay might be I don’t believe it. He can only describe the past because that’s all the aggregates can really do – describe what has happened. Their predictive value is very strictly limited because what may happen in the micro-economy, and above all, its interaction with the international micro-economy, will almost certainly throw those aggregates totally off balance. And that’s leaving out any poltical mayhem that might result from what the government is doing – or failing to do.

The 1970s was a difficult period in which the U.K. and the U.S. saw jobs vanish in key industrial sectors. To stop the rot and effectively mask the lack of income growth by average workers, a new engine of growth had to be found. Enter the financial sector.

this is what i think triggered the biggest factor for the depression. and that collapse of incomes has continued almost unaffected since (with a minor up tick from 1995 – 1999) after which we fell back again. and the only thing that drove the economy was credit.

reminds me of a TV commercial with a man on lawn mower, who was saying he was up to to eye balls in credit. seems that was who some finance company wanted to loan to.

Too bad too many people do not understand or will not accept or continue to ignore the fact that this particular crisis is borne from too much PRIVATE debt and therefore can’t accept the necessary remedy unless they wish to see a complete collapse.

These are new and different times. Much experimentation has taken place. The basic rules and axioms of economics have almost been made meaningless (government, big business and the private sector have caused this through immorality and short-sightedness). Prediction and forecasts are almost impossible (inflation? hyper-inflation? deflation? double dip recession? stagflation? greater depression? secular series of lower case “w’s”?) because of all the experimentation, alteration and the continuing variables of government interference (with the potential of changing every 4 year term). All we can be certain of is surprise, unintended circumstances, damage from well-meaning but uneducated forces, damage from opportunists.

I think you have managed to add a new perception into this whole crisis, next to Mish’s deflationary views and government waste and cronyism and Barry’s pragmatic approach to trading and no-bullshit attitude.

Totally agree that the recovery is fake, that it was finally enabled by the ban of mark-to-market, and that the only tool of government now and the last 25+ years has been asset inflation. I was still surprised how easily people became willing to pretend that the banks are solvent and assets are cheap – I thought they would have at last learned better after all the bubbles. So they cranked up their tool once more, but the real economy is being barely influenced by it, that is why fiscal stimulus is the only thing keeping tepid “growth” alive.

Still, I am not sure that savings by one sector must necessarily be lent ot another, as there may be no worthy projects for financing. I am also not sure that there is some accounting rule that works b/w the public and private and foreign sectors (similar to the current and capital accounts for the foreign sector)

And finally, are you really sure that Obama & co wll abandon the stimulus? Would they do it because of false economic beliefs or are they pressured by China and other creditors?

Public debt/private debt are ultimately the same thing. Deficit spending by government to allow private debt to be eliminated is merely a shift of the debt from current obligation to future tax obligation – which falls ultimately on individuals. The debt is not destroyed. Confidence for repayment is increased somewhat, depending on the culture and politics of the country, but when the total gets to a point where it obviously cannot be repaid and still allow individuals in that country to live reasonable lives, there must be default or default-by-inflation. There is a tipping point beyond which there is no recovery.

unfortunately the us is in bad shape and as much as people believe it is getting better, they are wrong. The total debt To GDP has gone up. Ultimately that is going to have to be paid back in taxes so the high end will get hurt unless they all leave. Debt break all great nations and people, this is a fact

“Deficit spending by government to allow private debt to be eliminated is merely a shift of the debt from current obligation to future tax obligation – which falls ultimately on individuals. The debt is not destroyed. ”

In answer to Edward’s question, I believe that after the mid term elections the government will stop supporting the economy, then announce a large spending and giveaway package about 9 months before the 2012 presidential election, since it is really about TPTB remaining in power. This could also possibly give them the ability to regain more power over the banks. Just my best guess though. Seems logical. Maybe they sacrifice Timmy too when political pressure heats up a little for helping the banks. That will be funny.

The U.S. economy cannot possibly work itself out of the greatest financial crisis in some 70-odd years in a mere 4 years and then expect to raise taxes on the middle class without a major recessionary relapse.

So, when you hear policy makers talking about reducing the deficit as soon as possible, what you should think is 1938 and continued depression.

So, why are the deficit hawks winning the ideological debate at the expense of the rest of the economy? haven’t they learned NOTHING??

Great *descriptive* analysis of what our problems are. Great work. But, what’s your *prescription* other than just maintaining the government prop indefinitely? Wouldn’t it be better, to wipe out the debt as fast as possible and just do a wholesale financial cleanup? I’m thinking of big nationalization of the banking system, wiping out the big banks-get rid of the bad assets as quickly as possible. Why prolong the process?

Interesting divergence of opinion here. I’ve been impressed by the arguments of Marshall Auerback and the Modern Monetary Theorists that more deficit spending is needed. The wallys of the world say that “Public debt/private debt are ultimately the same thing”, but that doesn’t seem to be true. The government can create money at will to pay debts denominated in fiat currency. (Didn’t the US government just do this to the tune of several hundred billion dollars? So, in fact, taxpayers will not have to pay these debts!) In fact, the government can spend more than it takes in without resorting to debt at all. As far as I can tell, these are facts, not opinions.

I hope the Ron Paul and such supporters out there realize that the one institution (since it will obviously be resolved by institutions and not corporations or individuals) that can avert this chain reaction is The Fed. If Bernanke disagrees with the political assessment that fiscal easing has to end he can continue regardless of what congress or Obama thinks, and a Fed intervention at step 4 would be a lot better than continuing down the list.

Not saying it will happen or anything like that, but if there is a silver bullet to prevent that scenario from going down, that/he would be it.

Also, can someone answer this for me?

If housing bottoms and the economy heats back up interest rates will eventually have to rise, whether modestly or severely (doesn’t matter here). With rising interest rates the longer a seller leaves his house on the market the more expensive it gets, leading to eventual price cuts. Doesn’t housing have to find it’s price to interest rate equilibrium (not just price with steadily low interest rates) before it bottoms? Anyway, I’m a rank amateur at this so don’t bite my head off please if it’s elementary and obvious to the rest of you…

One of the issues it doesn’t touch on, though, is China’s position as the world’s manufacturing center and it’s peg to the dollar. I imagine that through the USD inflation/deflation roller coaster ride, China will face immense domestic pressure and possibly civil unrest. I can imagine a painful transition as China transitions itself to a consumer-led economy as a recovery in the rest of the world stalls. Hopefully this readjustment provides some relief with employment as the USD weakens relative to the Renmimbi.

Secondly, the US trade surplus also goes hand in hand with our oil imports. I expect urbanization trends to continue with higher energy prices due to a weaker dollar. I expect natural gas prices to rise relative to oil. Food prices will be way up, especially beef. Airlines are screwed.

I have a question though. How long can the govt pick up the slack of the private sector? At the end of the day the govt is only 20% of the economy. How much borrowing capacity does the govt have before it gets in trouble itself? and is it enough to “save” the private sector?

My instincts say the underlying economy is far weaker than most econometric models are showing. Once the temporary stimulus measures subside, the real economy will continue to contract and the dollar will fall as tax revenues decline, deficits rise (even more) and global confidence falls.

The next stage of the decline will be a “fire sale” on assets to sustain the economy for a while longer. Foreign purchases of property and companies (stock or acquisitions) at rock bottom prices as Americans do everything in their power to maintain living standards on reduced incomes. This will accelerate our transformation from a capital rich wealthy to a capital poor, second tier economy.

Banks owning real estate is known to be a disastrous situation so they’ll prefer to wait a couple years to allow some of their borrowers to get back on their feet. Nevertheless there is: $1.8 trillion loans coming due in next three years. There will be a very rare and tremendous buying opportunity for foreign investors and blue chip REITs whether it’s distressed with big or small d. There will be a mass liquidation and this time there’s cash…

With respect to deficit spending, first I think we must continue this practice because the consequence of not doing so at this moment in time would be catastrophic. Why mainstream Republicans do not understand this is beyond me.

That being said, there are negative consequences but these are difficult to match up because they may be separated by many years and disguised by political actions, such as currency manipulations or changes in bank regulations as well as by business cycles, technology/productivity advances and changes in the global economic landscape.

Nevertheless, economies eventually revert to equilibrium. This equilibrium favors those economies that save and invest over economies that borrow and spend. This is no different than the behavior of individuals which in fact is what an economy essentially is – the collective actions of its individuals.

China is aware of this and has patiently undertaken the former approach knowing that in the long term they will prevail. The United States has taken the latter approach and now we are suffering the consequences.

It is amazing that our government can continue to borrow and finance our spending habits without the dollar collapsing completely. It must be the relative position of the USA to other nations who also are in bad shape.

My biggest concern is with how we are spending the money being borrowed. Nothing is wrong with paying for more cops on the beat or more federal, state and local government workers to keep their jobs, except that these activities are not self-sustaining. This type of deficit spending assumes that the economic contraction is only temporary and once the economy recovers the tax revenues will come back and the stimulus can be taken away.

However this is not a typical “business cycle” recession but rather a major and permanent contraction in demand. Therefore our deficit spending needs to be geared towards investments that will create self sustaining economic growth, by encouraging rapidly growing emerging technologies and by making our economy more competitive and productive in the global marketplace. These concepts do not seem to even appear on the radar screen in Washington. The Krugmans, Pelosis and Obamas don’t get it and the Boehners, Palins and Shelbys continue to expouse Hooverian economic policies of “tough love” at a time when a patient is still on life support in the intensive care ward.

I am still waiting for a rational approach to emerge on the national scene. Perhaps it will come next year. Desperation is the mother of invention. When times get tough perhaps enough folks will discard their dogmatic theories and pursue more rational policies (or they will self destruct). Let us hope it is the former.

If Harrison is correct and we ARE in a Depression (and I think we are….at least I am. I mean the whole Roubini / Spam thing made PERFECT sense to me. But remind me NEVER to eat the Hors d’oeuvres at one of his shindigs! I’ll be all like “Hey Nouriel, this pate shit tastes kinda weird…WTF??”), then you need to get yourself over to:

Thanks bsneath. It helps to know that people are concerned about our situation here in Detroit.

Gaucho had a question– “How long can the govt pick up the slack of the private sector? At the end of the day the govt is only 20% of the economy. How much borrowing capacity does the govt have before it gets in trouble itself? and is it enough to “save” the private sector?”

Oh I forgot to add that I don’t see the article mentioning over capacity in the system which was a major problem during the depression. For all production capacity that was added in Asia over the last 5 years there is now a big over capacity that is sinking prices in order to get demand.

Nevertheless, economies eventually revert to equilibrium. This equilibrium favors those economies that save and invest over economies that borrow and spend. This is no different than the behavior of individuals which in fact is what an economy essentially is – the collective actions of its individuals. China is aware of this and has patiently undertaken the former approach knowing that in the long term they will prevail. The United States has taken the latter approach and now we are suffering the consequences.

I’m not sure about this equilibrium concept. Clearly, we are not in equilibrium now, with China having a huge trade surplus with regard to the rest of the world. It seems that part of the way this will correct is that the Chinese currency will appreciate with respect to the dollar. Dramatic increases in the U.S. deficit would thus hasten the re-balancing that needs to take place…

Very interesting. The plus of this article is that it provides a template for improvements in my own blog. New Year’s resolution; write better articles. Simply write better. Simply write …

Otherwise, there is much to disagree with in this piece. Part of this reflects my own finance learning curve. However, it is hard to discuss a systemic breakdown of the economy without mentioning energy. The economic problems of the 1970′s and early 80′s were an outgrowth of over- dependence on fossil fuel rates of production that could not match ever upward ramping demand.

This is where we are now, demand is subdued by distress/collapse in the OECD while it expands exponentially in China. Somehow this meant to suggest China will succeed in place of America because it pursues the US’s squanderous energy strategy.

The US pursues the squanderous debt strategy of replacing debt with … even more debt. And you wonder why economists have ‘public relations’ problems.

This leaves money and ‘productive’ activities as relatively unimportant as all are dependencies of petroleum production. Mr. Market sez that the peak of energy availability was in 1998; $12 a barrel oil. We hold @ $75 a barrel now and Saudi Arabia is now making US monetary policy:

The real, as opposed to nominal price (of oil) is a powerful incentive to keep production under check. This leaves aside the issue of production constraints. The depletion landscape has changed since 1998. Many countries are producing as much as possible, this has little effect on price. Saudia has gained control of OPEC decision making. They have spare capacity, the rest of OPEC doesn’t. Saudia can let the others pump their fields empty. Doing so cannot effect prices significantly. OPEC’s oil has much greater money value than does the defaulting finance toys that OPEC has imported to entertain itself. OPEC is a monopoly. There are insufficient non- OPEC reserves to push onto the oil markets and effect prices in a meaningful way.

GaveKal recognizes the Niewe Hard Dollar relative to oil, but gets their takeaway is puzzling. The idea that low nominal energy prices, “would de facto justify the Fed’s decision to keep interest rates low for a long time ” suggests that low oil prices are a result of economic disorder sufficient to destroy oil demand. Maybe this is so. There certainly isn’t anything economically bullish about declining oil prices any more than high oil prices. Declining prices suggest the next leg of credit deleveraging has begun.

Rising oil prices alongside other commodities would reflect the success of Ben Bernanke’s ‘Zero Dollar’ strategy. Instead, the Fed has lost the power to control its own destiny; its strategy to bluff dollar inflation has failed. Wall Street finance is flooding the world with dollar denominated credit; Bernanke suggests that this is all real money. (Saudi oil minister) Ali al- Naimi has simply called the Fed’s bluff. After all, he has oil, Bernanke has nothing.

In this view through the kaleidoscope the denouement has already begun; the effects of a oil- backed US dollar are starting to be felt as short- dollar trades are being unwound. Ali al- Naimi has created a time machine, welcome to 1931.

The US could solve its debt problems tomorrow and its global economy would still fall apart.

“There is no chance that the U.S. can export its way out of recession without a collapse in the value of the U.S. dollar.”

We already export a lot. We may be able to fix the current account deficit by importing less. I wasn’t able to find a quick summary of how much of our imports are discretionary so I don’t know how realistic this is. But on an anecdotal level everyone seems to think that we buy a lot of crap from China…

@Detroit Dan

I hope you realize that when you say that the government doesn’t have to borrow to finance the deficit you are basically advocating the printing of money. At this rate we could completely eliminate the national debt (or why stop there… *all* debt!) by simply crediting bank accounts with boatloads of money. It’s just electrons in a computer anyway, doesn’t cost a thing! Except that afterward the a loaf of bread would cost 200 bucks…

“Ali al- Naimi has simply called the Fed’s bluff. After all, he has oil, Bernanke has nothing.”

The US is not a kingdom and Bernanke is not the king. Let’s compare countries to countries, shall we? Are you implying that the US doesn’t have anything the Saudis want? How is their agriculture going? Technology? Military?

1. Economics is not a zero sum game, though measurable production is a key part. It’s at least equally a confidence game. Good economies are made by people believing in their economy. Jolts that undermine confidence (like the 2008 banking collapse) are the biggest dangers to economies and the reason the Fed & US Govt justifiably stepped in with radical action and a “false recovery”
2. As the economy actually globalizes, the huge imbalance between have’s and havenot’s will mean that the US and other strong economies will have to suffer some serious downturns in relation to the rest of the world. This may be a necessary outcome of the eventual growth of a worldwide middle class to drive a global economy.
3. Debt is not a bad thing. One could argue that it was the huge amount of debt loaded into the GI Bill that created the home buying, entrepreneurialism and education that eventually led to the largest middle class the world had ever seen — and the model for all modern economies. The access to credit, and the trust and confidence of those accessing it, was the key to all that.

Pete from CA– The government does print money and credit bank accounts to pay for expenditures. The currency is a creation of the government. At any rate, there’s a long way to go before it generates inflation. Why worry about inflation when we it is not a problem now and we have 12-25 million jobless workers?

Inflation will be a concern as the economy approaches full employment of resources, including labor resources. We’re not anywhere close to that point…

Not exactly. This function is currently delegated to the Fed. The Fed is supposed to be independent, exactly so as to prevent populist politicians riding the wave of the 12-25 million jobless workers from ruining the currency.

You are right, of course, the Fed is printing money as we speak. You think they don’t print enough..? How much is “enough?” I think it’s naive to think that we can print ourselves out of unemployment.

Come to think of it, we CAN print ourselves out of unemployment. We just have to decrease the value of the USD to a level where the US minimum wage is worth less than the hourly wages paid in China/India/Malaysia/etc.

@ Detroit Dan, I would suggest we are not at equilibrium because it is in the best interests of China and other emerging nations to keep the $ propped higher against their currencies in order to stimulate exports and domestic investment. However the day will come when their domestic economies mature and we no longer have the ability to buy their goods. When this happens, the incentive to prop up the dollar will diminish. That is when we will be forced to make more of what we consume and export more than we import to pay back old debts. We will be much poorer since commodities are traded globally and cost more with devalued dollars. I think all of this will play out in the next year or two or it might take longer.

@Pete. Thanks for the reply. I’ve come under the influence of the “Modern Monetary Theorists”. These folks are unconventional economists, many of whom advocate that the government be the employer of last resort. You can read about their platform at the web sites of Bill Mitchell (of Oz) and Randall Wray (University of Missouri).

In regard to your question, “How much (deficit spending) is enough?”, the answer of course depends upon how the money is spent. I would start with several hundred billion for state and local governments, so they don’t have to lay off teachers, police, etc. A payroll tax holiday would help employers and middle class workers and give a boost to employment. I doubt that these steps would result in an overheating of the economy. If and when the economy overheats, then these boosts could be withdrawn…

Detroit Dan,
There is a limit to debt, whether public or private. Lots of private individuals run into this and, on occasion, countries do, too. We know, for instance, that the aggregate private debt levels in the US in 2007 were so high that $4 gasoline was enough to trip the trigger for a certain percent of the population (That was the spark that started the subprime collapse, you may remember).
When you are there, only four solutions exist. You can live with it year after year, letting the cost of that debt grind away your growth potential (see many articles on Japan); you can start to pay it down; you can default by one of two methods: a. don’t pay or b. pay with something worth less than you agreed to.
First question for you: what is the maximum debt ceiling for the US, public and private combined? We know it is not infinite; it is less than 10 times GDP… what is it? Now, if you cannot answer that question you should not be advocate increased debt creation (deficit-financed stimulus). To do so is irresponsible.
Second question: If you do have an idea what that limit is, how do you propose dealing with it when we get there? You have, as I said, four options. What’s your poison?

@bsneath– I agree with what you wrote for the most part, although I’m not sure about some things (but that’s my problem).

Again, I tend to agree with the Modern Monetary Theorists who say that the U.S. government should put people to work directly. Of course, they should be put to work doing something productive, and there are a lot of things that need doing. The MMT folks aren’t worried about the debt, and don’t seem to be worried about the devaluation of the USD. As Randall Wray wrote Tuesday (12/15/09):

You can be sure that no matter how misguided President Obama’s policies might be, he is not taking us down the path to a Zimbabwean hyperinflation. This is not the place for a detailed analysis of the probable course of the dollar. In coming months it might decline a bit, or rise a bit (I’d bet on the latter if I were a gambler)—but there will be no global run out of the dollar. For one thing, runners must run to something—and as recent reports suggest, Euroland’s prospects look dire. That leaves smallish nations (Japan, the UK—both with their own problems) or big nations (China, India) that are too risky for foreigners. The best place to park savings will remain the US dollar. [Randall Wray]

@Pete– We currently have 12-25 million unemployed people in the U.S. I’m not sure if you think this situation is better than putting people to work doing something useful. Perhaps you have some other solution in mind. As with Randall Wray, I just don’t see that putting people to work, rather than having them be homeless or collecting unemployment, is the road to ruin.

Government debt denominated in our own currency is not obviously a problem as far as I’m concerned. I own a lot of that debt myself. If the government were to print money and give it to me in exchange for my Treasury bonds, I would just move it to some other savings account, such as an FDIC insured checking account. The bonds are quite liquid anyway, so replacing them with cash or some other liquid investment wouldn’t cause me to increase my spending on anything that goes into CPI.

Same with the Chinese, I’d guess. If they don’t want our Treasuries, they will have to do something else with their savings as long as they have a big trade surplus with the U.S. If they don’t want to accumulate so many dollars, then they’ll have to figure out a way to sell their products to others. At any rate, the U.S. can liquidate its debt at any time with no net addition of liabilities. Rather the U.S. can just substitute cash for bonds. Those who are saving in bonds will find some other means of saving.

Hope this helps to understand my thinking. I look forward to any further feedback from you folks…

I wanted to wade into the comments with a few points. First, from a policy perspective dealing with this mess is problematic because politicians do not want to take the pain associated with either decreasing aggregate demand by following an Austrian approach or with liquidating excess capacity. Barry’s book “Bailout Nation” comes to mind.

In my view fiscal stimulus is more potent in a depressionary environment (see Marshall Auerback’s post at CW here: http://www.creditwritedowns.com/2009/12/bernanke-doesnt-understand-the-basic-economics-of-central-banking.html). But, it’s no panacea. What Keynesians fail to consider is the need to reduce overcapacity that resulted from overinvestment that easy money created (think dark fibre in the Telecom bubble or exurb housing in the housing bubble). You can’t bail out bankrupt companies and add fiscal stimulus thinking this solves anything. As soon as the prop is removed the overcapacity comes back into full view and recession returns.

So, liquidating excess capacity is key and that means job losses. The way to prevent this from leading to social unrest and to help the households sector is to add fiscal stimulus while maintaining rates relatively high (to promote saving). So my prescription would be: let bankrupt companies go bankrupt, add countercyclical stimulus, increase support of automatic stabilizers, keep interest rates higher (you can’t get savings with zero rates – it is the lack of credit demand and not the lack of supply which is driving the bus.), stop printing money.

The result of this prescription is a deep downturn attenuated by fiscal stimulus and shortened by the quick reduction in mal-investment.

But, of course, we all know politicians would never do this so we can only hope they get some of it right.

Mr. Harris: Eloquently stated thesis—thank you so much for having this out there….I too saw through this veneer of pseudo recovery some 36 months ago and began doubting the stratospheric levels of intangibles around the world as early as 2004 and doubted the speculative fervor being touted by popular TV by Realtors & Builders with the many programs devoted to ‘flipping’ homes—-what better evidence that the “Greater Fool Theory” is fully operational?..
However, the most amazing evidence of the current situation, which is just like the 800 lb gorilla syndrome is the astronomical PE of the S&P 500, not just because its traded back from its crater of a year ago but also because of the continuing deterioration of the earnings as well…..what doesn’t the public understand about gravity?

Albeit your very astute presentation….I submit to two considerations….
First, that your prognostication of repeating “W” formations may not be “Ws” but will be lower right down legs that will become very long and flat “Us” instead…..although I specifically agree with you that these market cycles will do in the life cycles of the Boomers and will take many decades to recover long after Boomers & Buffets have left this world…..
Second, I wish to float and idea of uniqueness in opposition to your deflation forecast not because I believe that the result will be inflation but because I submit that if the US astutely grasped control of its FRB & Treasury from the current fraternity of Bernanke & Co ….that the US has a very unique opportunity to be the Treasury to the World…..
The US is the only economy with market operations, liquidity, size, confidence an operational mechanisms to store, trade, exchange and finance the wealth of the world….i.e. who in their right mind would trust a Chinese, Japanese or Russian markets to bank their wealth….who in their right mind would corner themselves in limited economies like the UK, France or Germany….
If the Obama Administration and the progressives in Congress will truly take the ‘bull’ by the horns and whack its errant gonads to create true government fiscal policy not unlike how Executive & Legislative branches create military policy and throws Wall St & Main St and their bastard cousins in the FRB & Treas under the wheels of egalitarian reforms to reorder the US equilibration…..THEN…
As the mega nation of warfare and strength…we sure-up the same focus on finance….not the barnyard concepts that took us down the present paths…..the US to be the juggernaut….
Therefore….looking at these two scenarios…I submit a third option for the US…..
That the US mediums of exchange, the dollar and treasury bills, notes an bonds will become the store of all world wealth and the US will launch itself into a whole different realm of reality of productivity and opportunity for its populace….one that is so structurally different and sophisticated that there is no need of a new world order because it will be the US’s order for the world….one where inner city strife, inter-racial problems, health care deficiencies, education inadequacies that there will be a true transcendence of Mr. Jefferson’s demand for ‘equity’ for each and every American regardless of race, gender or origin…or What the light on the hill was originally all about….!!!!….RG 122009

Obviously I would prefer to have the unemployed do useful work. Emphasis being on “useful”, meaning an investment that will in turn aid organic (as opposed to government stimulated) growth. I am skeptical about the government’s ability to do this.

Franklin411 often posts on this blog about the crumbling infrastructure, and that the government should spend money on roads/bridges/whatnot. Maybe he is right. Where I live, they recently resurfaced a 2×4 lane road. There was a sign saying something about federal recovery funds at work. Are we now better off? Maybe. I for one didn’t think there was anything wrong with the road before they resurfaced it…

@Pete — Thanks again. Good comments. My opinion is that we need government, so we’d better make it good. Both good and bad government action is certainly possible.

It helps to look at what has and has not worked elsewhere. In that vein, let’s look at Japan, which has had a much higher level of government spending for 20 years. It hasn’t cured their economic woes, but it also hasn’t debased their currency (which has actually strengthened). And they have been able to maintain a high standard of living, including universal access to good quality health care and moderate levels of unemployment. However Japan does have a trade surplus, so the situation is not fully comparable to that of the U.S.

As I mentioned above, I think that the federal government should provide block grants to the states, on a per capita basis. That would at least counter the dramatic deflationary effects of plummeting state tax revenues. Also, a payroll tax holiday would seem to be a fairly progressive and equitable way of boosting the economy with a fiscal stimulus. And I do think that a lot of the New Deal infrastructure programs were of lasting value, so we should do more of that including, especially, clean up of the environment and management of parks.

@wally– A point I’ve been trying to make is the public and private debt are substantially different. The federal government can always pays its debts (if denominated in the currency it controls) by just crediting the appropriate bank accouts. Private organizations and individuals do not have this option, and that seems like a major difference.

what is the maximum debt ceiling for the US, public and private combined? We know it is not infinite; it is less than 10 times GDP… what is it? Now, if you cannot answer that question you should not be advocate increased debt creation (deficit-financed stimulus). To do so is irresponsible. [wally]

Anyway, I wish I had all the answers (such as how high the combined federal + private + other government debt could be), but I don’t.

Second question: If you do have an idea what that limit is, how do you propose dealing with it when we get there? You have, as I said, four options. What’s your poison? [wally]

Again, I’ll just respond with regard to the public debt (since I don’t consider public and private debt comparable for the these purposes (as explained above)). The government can always stop issuing debt. Debt is not necessary to finance public expenditures. The government can also buy up existing debt (quantitative easing), which our government has done this year to the tune of several hundred billion dollars with no discernible adverse effects.

If inflation becomes a problem, the government should in general reduce the deficit.

Hope that helps to understand my thinking. Glad to hear more feedback from everyone…

Just wanted to say that I don’t think Ben Bernanke, Larry Summers, Timmy ‘water boy’ for Vampire Squid from Hell or any other Obama economic team clown can construct a valid data point reply to this provocative post!

Yup. Nice article, harrison. Several of us have been stating the same “obvious” points here for the last 2 years, yet the “obvious” isn’t necessarily obvious to the general public or the powers that be. Cassandra, Cassandra.

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Ritholtz has been observing capital markets with a critical eye for 20 years. With a background in math & sciences and a law school degree, he is not your typical Wall St. persona. He left Law for Finance, working as a trader, researcher and strategist before graduating to asset managementRead More...

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